Top quartile private equity performance is something every institutional fund aspires to. Of course, every single PE fund claims to be top quartile, which would seem to be mathematically impossible.
David Swensen and his team at Yale have put together one of the most enviable track records in this space. This passage comes from the most recent Yale Endowment Fund update:
Yale’s private equity program, one of the first of its kind, is regarded as among the best in the institutional investment community and the University is frequently cited as a role model by other investors. Yale’s private equity strategy emphasizes partnerships with firms that pursue a value-added approach to investing. Such firms work closely with portfolio companies to create fundamentally more valuable entities, relying only secondarily on financial engineering to generate returns. Investments are made with an eye toward long-term relationships—generally, a commitment is expected to be the first of several—and toward the close alignment of the interests of general and limited partners. Over the past twenty years, the private equity program has earned 36.1 percent per annum.
Using the handy rule of 72 would tell us that Yale would double their money every other year with 36% annual returns. Not bad.
Unfortunately these numbers don’t tell the whole story. Twenty years ago Yale’s Endowment was roughly $4 billion. Let’s assume 20% of that was in private equity (the allocation is now 33%). Earning an annual return of 36.1% would have turned that $800 million allocation into $380 billion. The funny thing is the current endowment value sits at just $23 billion, a fraction of the potential stated PE growth.
Why is this the case?
Here are a few caveats that rarely get mentioned when discussing private equity returns:
IRRs are not compounded returns. There is a huge difference between an internal rate of return (IRR) and a compounded rate of return. IRRs tell you how well the investor did with the capital they employed, but not when they employed the capital or how much of the capital they used.
The magnitude of the cash flows matters. Let’s say your pension fund makes a $10 million commitment to a private equity fund. It’s highly likely that just $6-$7 million of that capital will be invested by the PE fund. This is because, on average, PE funds only call roughly 60-70% of committed capital (another issue is that many funds still charge fees on the $10 million of committed capital, so investors are paying much more than a 2% management fee, but I digress).
This means that while investors may be receiving decent returns on their PE investments, it’s being earned on a smaller capital base than they may realize, thus diminishing the impact of the returns on the overall portfolio.
The timing of the cash flows matter. IRRs are used because they are meant to take into account the timing of cash flows. When our hypothetical pension fund makes its $10 million commitment to a PE fund, they don’t simply hand over that money all at once. It gets invested as opportunities arise. The investment period for a PE fund can last up to 10-15 years. But the IRR stat places a lot of weight on the earliest cash flows. When you invest and how quickly you get your money back can have a huge impact on the IRR calculation.
In the Yale example, the high IRRs they earned in the 1980s are probably accounting for the majority of their enormous reported return. From year-to-year, that return probably hasn’t changed much over time. Short-term successes and failures can distort IRRs and don’t tell the whole story. IRRs also don’t take into account the opportunity cost of sitting in cash or other investments for a number of years as investors wait to have their capital deployed by PE firms.
They’re not benchmarked correctly. A number that far too few investors or funds use is a multiple of capital. A 2x multiple would mean that an investor in a fund doubled their money (although, to be fair, venture capital funds pay more attention to these numbers). The multiple of capital is much more tangible than an IRR.
Also, when making private to pubic market comparisons, many PE funds use a constant public market index, such annual S&P 500 returns. A more apples-to-apples comparison would compare private investments and public investments on a cash-flow weighted basis as PE investments are made. So it would look at how that investment would have done in the S&P 500 during the same time frame the cash was put to work. It levels the playing field, so to speak. And this doesn’t even take into consideration the leverage or illiquidity involved in a PE fund.
Everyone does things a little differently. Because of all of these issues, there really are no standards in the institutional investment world to account for private equity returns in a portfolio. Compounded returns would probably understate returns, while IRRs overstate them. The numbers you see from most PE firms and institutional investors alike are not what they appear to be at first glance.
I’m not trying to suggest that Yale is over-stating returns purposely here. David Swensen and team’s track record speaks for itself. It’s unmatched in the institutional investment world and private equity has played a large role in their success. But the return numbers that you see from certain funds aren’t always what they’re cracked up to be.
Investors are often far too believing of statistics without placing them in the correct context.